Once targets of tax hikes, hedge funds now unscathed

A year after falling into the crosshairs of lawmakers, private equity and hedge fund managers have emerged unscathed, surprising even some of the highly paid lobbyists they hired to protect them.

A costly lobbying campaign and an unforeseen partisan showdown over Democrats’ pay-as-you-go budget rules helped these Wall Street titans duck the legislative threats leveled against them — at least for the time being.

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“We did think until fairly recently that the PTP legislation would get enacted,” said a member of the private equity industry’s lobbying team, referring to a provision that would more than double the taxes on private equity firms and hedge funds that go public.

Lobbyists insist the industry isn’t in the clear, particularly if a Democrat sits in the White House in 2009. And they are quick to credit larger political forces — namely, the brawl over pay-go — rather than their own wiles in heading off the threats.

But some argue that the outcome shows that lawmakers rushed to attack an industry before doing their homework and ultimately found it a lot more complicated than they expected.

“They put hedge funds in their sights because they didn’t understand who they were. Instead of setting it up to learn what they were and how they worked, they just fired,” one financial services lobbyist said.

Despite several hearings on the taxation of hedge funds and private equity firms in the House and Senate, Congress approved no legislation targeting the industries.

Likewise, an effort to more than double the tax rates on fund managers’ carried interest failed to attract the support of enough Senate Democrats, and was uniformly opposed by Republicans. Another proposal, to ban hedge fund managers from using offshore tax havens to defer taxes, fell victim to Senate Republicans’ refusal to attach any tax increases at all to legislation to shield millions of Americans from the Alternative Minimum Tax (AMT).

The two industries’ success at dodging these threats was mostly the result of a very dry tax year, argued Marc Gerson, a tax expert at Miller & Chevalier who served as majority counsel to the House Ways and Means Committee under former Chairman Bill Thomas (R-Calif.).

“It’s not like there were a lot of raisers enacted and these didn’t get picked,” he said. “The reality is that there was very little tax legislation done this year and very differing views with respect to pay-go.”

Yet the industries have also spent lavishly on lobbyists and poured money into campaign coffers. The Blackstone Group, one of the largest private equity firms, spent $3.74 million on lobbying fees in the first half of 2007 alone, according to reports filed with the Senate. Meanwhile, the hedge fund industry has given $5.4 million to federal lawmakers this election cycle, up from $4.8 million last year, according to OpenSecrets.org.

Once educated by lobbyists, lawmakers were surprised by the complexity of two industries that had been caricatured in the press, a lobbyist familiar with the effort argued.

In particular, they discovered that carried interest — a portion of the profits that fund managers receive in exchange for services they perform to a partnership — was widely used in the real estate and venture capital industries, complicating any proposal to change its tax treatment.

“Guess what? Carried interest is not a hedge fund issue,” the lobbyist argued that the lawmakers learned.

An early sign the carried interest provision would fall flat occurred when House Democrats decided not to carve out the real estate and venture capital sectors from the carried interest provision, according to the member of the private equity lobbying team.

The measure passed the House as an offset to a one-year AMT patch with the support of all but a handful of Democrats. But sensing that carried interest was too controversial in the Senate, the House leadership scrapped the measure in favor of the provision banning offshore tax deferrals by hedge funds when it passed a second AMT patch weeks later.

Some Republicans had voiced support for at least reviewing the deferral provision. But by then, Senate Republicans had adopted an unyielding opposition to attaching any tax increases to the AMT patch — a shift that few lobbyists predicted earlier in the year.

“You had [GOP] members who were very open to at least looking at the idea of a patch that was paid for, extenders that were paid for. That changed,” said the president of the venture capital trade group, Mark Heesen, who argues that his sector has been wrongly grouped with the private equity industry.

The unexpected political fight over pay-go blocked some provisions that otherwise might have had a chance had they been positioned differently and moved earlier in the year, argued a senior Senate GOP tax aide: “It was a strategic mistake to try to frame the offsets on the AMT because they picked the sweet spot of where Republicans were united.”

The private equity industry will be targeted even more next year, the aide argued, because, “Democrats will be more organized next time.”

Heesen agreed that the AMT acted as a surprise buffer against tax increases for the private equity industry as well as his sector this year, but he stressed that carried interest could be a revenue raiser for other tax relief.

“Can a member of Congress use carry to pay for something else next year that doesn’t have the emotional baggage of the AMT? The answer is yes.”